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Retirees: Beware of Complacency

Christine Benz
Jeremy Glaser

Jeremy Glaser: From Morningstar I'm Jeremy Glaser. I'm here with Christine Benz, she's our director of personal finance. We're going to look at some risks that retirees may be underestimating.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So perhaps with the notable exception of very low bond yields, low savings account yields, it's been a pretty good couple of years for retirees. But you think this might be engendering a sense of complacency.

Benz: I think it does. I mean when I think about my own portfolio, for example, we've had very strong equity market returns. It's easy to just let your winners ride, right, to not do that rebalancing, not do that portfolio maintenance that you might otherwise do. We've come through a period where the U.S. market has generated a return of roughly 14% on an annualized basis over the past five years. Those are very, very strong numbers. Anecdotally, out and about, speaking to retired audiences, I sometimes talk to retirees who tell me that they have portfolios that are 100% stocks, and they might be dividend-payers that are giving them the income stream that they seek. But I just would like to encourage all retirees to make sure that they're staying mindful of the risks that could lurk within their portfolios, and making sure they're building in hedges in case current conditions don't persist into the future.

Glaser: Your first retirement risk is related to the equity market. That we could potentially see a shock and that might be something a lot of retirees aren't prepared for.

Benz: That's right. And it's hard to say what would be the catalyst for some sort of a large equity market shock. But you know we're looking at a couple of key things, one is that corporate profitability here in the U.S. appears to be slowing down, is slowing down. And the other key thing is that equity market valuations, because we've have had this tremendous rally, they're just not what they once were. So, when we think of what is the biggest trigger for market sell-offs, while there might be some sort of macroeconomic event combined with high equity prices, those two things working together usually contribute to some sort of a market sell-off. Whether it's imminent or not is anyone's guess, but I think it's something to stay attuned to when you think about your portfolio mix today.

Glaser: What's the solution to this though? You probably don't want to go to zero stocks.

Benz: Absolutely not, retirees do need to hold equities in their portfolios. Certainly, given how low bond in cash yields are today, they need to hold equities in their portfolios, but as you know I'm a big believer of using your anticipated spending horizon in retirement to decide how you segment your portfolio. So, use that spending horizon, combine it with the probabilities of having a positive return from each of these asset classes, and use that to decide how to shape your portfolio. So, what I typically tell retired investors to do is to think about parking one to two years worth of living expenses in true cash instruments, kind of batten down the hatches with that portion of your portfolio, because you don't want to have your spending buffeted around. And then step out on the risk spectrum from there.

So, in my model portfolios for example I've typically staged it by putting the next three to 10 years worth of living expenses in bonds, generally a high-quality bond portfolio, kind of stair-stepped by risk level starting with very high quality short-term bonds and then moving into more of an intermediate-term product. And finally, once you have that time horizon of 10 years or more, that's where you can hold stocks, because stocks over a 10-year period even though we might have a market shock in the near term, over a 10-year period they've been remarkably reliable, where they've had a positive return, in about 90% of rolling 12-month periods.

Glaser: Let's look at that second risk, which is inflation. Bob Johnson, who's our director of economic analysis, says this is something that worries him particularly for retirees, lots of things that they buy like services. Is this a risk that you think is being underestimated?

Benz: I do, and Bob has done a great job of keeping tabs on inflation for us. He has noted recently that even though inflation is still really low, under 1.5% when you look at CPI, Bob has noted that that's quite an uptick from where it was even a year ago. And the other reason I think retirees need to stay especially mindful of inflation is that their consumption baskets may look different from the general population. So, one statistic I keep an eye on is the CPIE, CPI for the elderly. It attempts to quantify what inflation looks like for older adults, and a couple of categories have been inflating higher than the general inflation rate. So, housing costs, where retirees tend to spend a bigger share of their budgets than the general population, housing costs have been inflating higher than the general inflation rate. And healthcare costs, perhaps more importantly, have been seeing an higher rate of inflation. Those two costs will tend to hit retiree budgets hard. So, it does make sense to think about embedding inflation protection in-retirement portfolio.

Glaser: And how would you do that? What are the best tools for hedging against inflation?

Benz: Well, a couple of asset classes getting back to stocks, I just said don't hold too much in stocks, but you definitely want to hold some, because when we think about the asset class with the best shot at out-earning inflation over time, it's equities. So, provided you've got a long enough time horizon, equity should have positive returns relative to inflation. So, holding ample equity exposure, though not too much, and also holding some inflation-protected bonds, so that to the extent that you have fixed-income investments you want to make sure that some of them are inflation protected. Treasury Inflation-Protected Securities are widely considered the purest inflation hedge that you could add to a portfolio. The basic idea is that you get a little nudge up to keep pace with inflation as CPI goes up.

When I look at the allocations of our colleagues at Morningstar Investment Management, that they put together for their clients, they typically it's steer roughly 20% to 25% of fixed-income portfolios to some sort of inflation-protected bonds.

Glaser: Given how slow the Federal Reserve has been to normalize monetary policy, it feels like we've been talking about rising rates for a long time, which is not exactly a secret risk. But you think it's one that may be underestimated.

Benz: It may be, I think retirees have probably been warned to keep an eye on this issue for what six, seven years now and really, interest rates have remained quite low through this whole period. I do think it's it's not one to lose sight of particularly if you have a significant share of your portfolio in fixed-income investments as many retirees do. I'm a big believer in running all of your bond holdings through what we've called a duration stress test. So, find the duration for a bond fund that you own, find the yields, and subtract that yield from the duration. The amount that you are left over with is roughly the amount that you could expect to see that product loose in a one-year period in which interest rates went up by one percentage point. That's a big jump up in interest rates, I don't think anyone's forecasting that we will see that sort of rate shock anytime soon. But nonetheless it's a worthy exercise for investors' bond portfolios. For many investors holding a core type bond fund they may see if they run through this exercise, that, you know what, the losses probably won't be catastrophic, if we do see interest-rate increases. But nonetheless it's something you want to brace yourself for. 

Also, keep an eye on things that investors have been using as bond substitutes. So, for example utilities and REITs will probably be pretty vulnerable in a rising interest-rate environment as well. So, take a look at those categories, make sure that you haven't allocated too much to those categories and if you have steered a significant portion of your portfolio to them, make sure that you are prepared for them to experience a little bit of vulnerability in a period of rising rates. We've in fact seen a little bit of that just in recent months, where we've seen utilities category for example come under some pressure due to this expectation that rising rates could be on the rise.

Finally, the last point I would make about rising yields, Jeremy, is that in many ways this can be a good thing for retired investors as many of them know they've been operating in this very yield-starved environment when higher yields do begin to come online, that will be beneficial for retirees and will offset some of the weaknesses that they may experience in other parts of their portfolio.

Glaser: Christine, thanks for highlighting these for us today.

Benz: Jeremy, great to be here.

Glaser: From Morningstar, I'm Jeremy Glaser. Thanks for watching.